RBI introduces new guidelines to ensure fairness and transparency in penal charges on borrowers

In a move aimed at promoting fairness and transparency in the lending sector, the Reserve Bank of India (RBI) has issued comprehensive guidelines for banks and other regulated entities (REs) on the imposition of penal charges on borrowers. The RBI governor Shaktikanta Das had first announced this during the April monetary policy.

Das in April said that these rules would be applicable to all entities regulated by the RBI, including all commercial banks, co-operative banks, NBFCs (including housing finance companies), and All India Financial Institutions like EXIM Bank, NABARD, NHB, SIDBI and NaBFID.

The new guidelines, which come into effect from January 1, 2024, seek to curb divergent practices among lending institutions and ensure that borrowers are not burdened with excessive charges for defaults or non-compliance.

Under the existing framework, lending institutions had the autonomy to establish policies for the imposition of penal rates of interest. However, the RBI's supervisory reviews uncovered varying practices among REs, leading to customer grievances and disputes. To address these concerns and establish a level playing field, the RBI has introduced a set of clear directives for the industry.

One of the key principles outlined in the guidelines is the distinction between "penal charges" and "penal interest." The RBI emphasized that penal charges are intended to foster credit discipline and should not be utilized as a tool for revenue enhancement beyond the contracted interest rate. Consequently, penal charges shall not be levied in the form of penal interest added to the loan's interest rate. Moreover, the RBI prohibits the capitalisation of penal charges, meaning that no further interest can be calculated on these charges.

To ensure uniformity and adherence to the new guidelines, REs are instructed not to introduce any additional components to the interest rate. Instead, they are required to formulate a board-approved policy for penal charges or similar charges on loans, ensuring that the quantum of these charges is reasonable and aligned with the non-compliance of material terms and conditions of the loan contract.

In a bid to safeguard individual borrowers, the RBI specified that penal charges for loans sanctioned to non-business individuals should not exceed the charges applicable to non-individual borrowers for similar non-compliance. The guidelines also mandate that the quantum and rationale behind penal charges must be clearly disclosed to customers in the loan agreement, the Key Fact Statement (KFS), and prominently displayed on the REs' websites.

Additionally, REs are required to communicate applicable penal charges to borrowers whenever reminders for non-compliance are sent. Any instance of levying penal charges and the reasons for such actions must also be communicated to borrowers.

These guidelines will be applicable to all fresh loans availed or renewed from January 1, 2024. For existing loans, REs must transition to the new penal charges regime at the next review or renewal date or within six months from the effective date of the circular, whichever comes earlier, RBI said in the guidelines released on Friday.

The regulator clarified that these guidelines will not extend to Credit Cards, External Commercial Borrowings, Trade Credits, and Structured Obligations, as these products are covered under product-specific directions.

Earlier, the central bank noted that many REs use penal rates of interest, over and above the applicable interest rates, in case of defaults or non-compliance by the borrower with the terms on which credit facilities were sanctioned.

RBI said that the intent of levying penal interest or charges is essentially to inculcate a sense of credit discipline among borrowers through negative incentives and to ensure fair compensation to the lender. Penal interest or charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest, it said.